Chapter 09_Hand-out 8

Chapter 09_Hand-out 8 - CHAPTER 9 THE CAPITAL ASSET PRICING...

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CHAPTER 9 THE CAPITAL ASSET PRICING MODEL 9.1 THE CAPITAL ASSET PRICING MODEL 1. The CAPM and its Assumptions The capital asset pricing model (CAPM) is a set of predictions concerning equilibrium expected returns on risky assets. Harry Markowitz laid down the foundation of modern portfolio management in 1952. The CAPM was developed 12 years later in articles by William Sharpe (1964), John Lintner (1965), and Jan Mossin (1966). The time for this gestation indicates that the leap from Markowitz's portfolio selection model to the CAPM is not trivial. We summarize the simplifying assumptions that lead to the basic version of the CAPM in the following list. The fundamental idea is that individuals are as alike as possible, with the notable exceptions of initial wealth and risk aversion. We will see that conformity of investor behaviour vastly simplifies our analysis. 1. There are many investors, each with an endowment (wealth) that is small compared to the total endowment of all investors. Investors are price-takers , in that they act as though security prices are unaffected by their own trades. This is the usual perfect competition assumption of microeconomics. 2. All investors plan for one identical holding period. This behavior is myopic (short-sighted) in that it ignores everything that might happen after the end of the single-period horizon. Myopic behavior is, in general, suboptimal. 3. Investments are limited to a universe of publicly traded financial assets, such as stocks and bonds, and to risk-free borrowing or lending arrangements. It is assumed also that investors may borrow or lend any amount at a fixed, risk- free rate. 4. Investors pay no taxes on returns and no transaction costs (commissions and service charges) on trades in securities. (In reality, of course, we know that investors are in different tax brackets and that this may govern the type of assets in which they invest . In such a simple world, investors will not care about the difference between returns from capital gains and those from dividends.) Furthermore, actual trading is costly, and commissions and fees depend on the size of the trade and the good standing of the individual investor. 5. All investors are rational mean-variance optimizers, meaning that they all use the Markowitz portfolio selection model to construct efficient frontier portfolios. 6. All investors analyse securities in the same way and share the same economic view of the world. The result is identical estimates of the probability distribution of future cash flows from investing in the available securities; 1
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that is, for any set of security prices they all derive the same input list to feed into the Markowitz model. Given a set of security prices and the risk-free interest rate, all investors use the same expected returns, standard deviations and correlations to generate the efficient frontier and the unique optimal risky portfolio. This assumption is often referred to as homogeneous expectations or beliefs. These assumptions represent the “if” of our “what if” analysis. Obviously, they
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Chapter 09_Hand-out 8 - CHAPTER 9 THE CAPITAL ASSET PRICING...

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